Wednesday, September 21, 2011

I've seen a lot of talk lately about how the CPI is way over-stating inflation, since its largest component—owner's equivalent rent—has increased over 7% since the end of 2006. Housing has contributed to inflation? How can that be if we all know that home prices have collapsed. Ha, ha.

The chart above helps to understand what is really going on. Due to the extreme volatility of housing prices in the 1970s, in the BLS decided in the early 1980s to switch from using home prices as an input to the CPI to instead using "rents," since they don't tend to change as much. This decision remains controversial, but as the chart shows, rents (which are estimated) have been much more stable than prices, and over time the two have tracked pretty well. If the CPI is overstating inflation today because it uses rents instead of prices, then it was hugely understating inflation in the late 1990s and early 2000s. Regardless of whether you had used housing prices as an input to the CPI, or rents, by now the cumulative amount of inflation you get is roughly the same. The difference between prices and rents evens out over time, which stands to reason.

This chart uses all the available data from Case Shiller, and that data only includes the prices of the 10 largest metropolitan markets, so the fact that prices have increased about 16% more than rents since 1987 is not to be given too much importance. The important thing is to see how the two series track each other over time. It's my understanding that rents today (which are widely reported to be rising) are becoming expensive relative to the cost of purchasing a house. So an ideal version of this chart might show that owner's equivalent rents have risen more than housing prices over the past several decades. But in any case, it disproves the allegation that the BLS is mis-reporting inflation. Rents and housing prices have come back into line, after a period in which housing prices were grossly inflated.

17 comments:

I don't follow Scott Grannis on this one. House prices have been cut in half since 2006. Mortgages rates have tumbled.

But housing as measured by the CPI is becoming more expensive?

Usually, I agree that saying the BLS under- or over-counts inflation is not sensible. However you define inflation or measure it, there are weaknesses and trade-offs. Any method for measuring inflation can be criticized.

If you buy a home today and are healthy, you are seeing real deflation. If you are renting, and need medical insurance or attention, you probably are seeing inflation.

But housing is such a large component of consumption that I sense the BLS is over-counting inflation now--as many conservatives have been saying for years anyway, for a variety of reasons.

One thing is for sure--inflation is so low, that reasonable people are having debates as to whether we are in deflation or inflation.

It's simple: If you're a renter, having a roof over your head has been a steadily increasing expense and that's what is factored into the CPI.

I believe the logic is that home prices, over the long run, will reflect the cost of rents.

As Scott points out, owning is very affordable right now (compared to rent), while four years ago, housing prices were very much overvalued.

Will rents decrease? With demand for rentals high (even in our depressed area of the USA), landlords have no incentive to decrease rental rates.

Housing is still very much in demand -- although the mix has shifted to renters vs. ownership.

Interesting to note, but in our area, homes less than $300,000 have a two month inventory of availability. And, $300,000 will buy 3,000 square feet. Our area of the USA has been very hard-hit by the housing debacle and recession in general, so to me, it's interesting that the rental demand and ownership demand (whether owner occupied or investor) are very high.

If inflation was understated in these numbers during the 90's and 00's, then is it possible that the Fed would have taken different courses of action, which may have avoided the worst of the last couple of years?

David: you make a good point, but the Fed understands the problems with the CPI. That's why they prefer to focus instead on the Personal Consumption Deflator, in which housing prices/rents play only a small role.

What should they have done differently? Paid more attention to the fact that the prices of a wide range of tangible assets were rising: gold, commodities, houses, while the value of the dollar was falling. These were the canaries in the gold mine saying that monetary policy was too easy.

Regarding recent Fed actions, I suspect that "Operation Twist" is a stealth effort by the Fed to buy back long-term debt held by China in order to retire this debt -- I suppose this could result in dollars finding their way back into the global economy -- in the end, the result is a kind of quantitative easing for global bankers -- a flood of dollars are about to flood the global economy indirectly via the Chinese...

Interesting. We came close to buying a house this month (I killed escrow about ten days in). In our local market (central California mountains) the "high" end (above 300k) still has a major disconnect to underlying value (as measured by rent). The low end is much more reasonable and I would agree that it would make sense to buy the 125k house instead of renting it. However, when I compared our rent ($1400) to the cost of ownership of the house we almost purchased (225k), factoring in taxes, insurance, etc, renting was still very close to owning over ten years. With no risk, except for possibly having to move, this is a no-brainer for me in the current market. The nicer homes, at least around here, still are better to rent than to buy. Another 10-15% off the sales prices would probably change my mind.

In my own view, it would be more wise to buy rather than just rent. If you cannot buy right away, meaning you do not have money yet, there are certain situations where you can ask for rent-to-own situation. At least, you have security that when you are able to pay the price little by little, you can be guaranteed of already owning the property.